India: Foreign Portfolio Investment In India: SEBI Creates A New Class Of Investors

Introduction

In order to harmonize the various available routes for foreign
portfolio investment in India, the Indian securities market
regulator i.e. Securities Exchange Board of India
("SEBI") has introduced a new class of
foreign investors in India known as the Foreign Portfolio Investors
("FPIs"). This class has been formed by
merging the existing classes of investors through which portfolio
investments were previously made in India namely, the Foreign
Institutional Investors1
("FIIs"), Qualified Foreign
Investors2 ("QFIs") and
sub-accounts3 of the FIIs. Previously portfolio
investment was governed under different laws i.e. the SEBI (Foreign
Institutional Investors) Regulations, 1995 ("FII
Regulations") for FIIs and their sub-accounts and
SEBI circulars dated August 09, 2011 and January 13, 2012 governing
QFIs, which are now repealed under the SEBI (Foreign Portfolio
Investors) Regulations ("FPI
Regulations") that govern FPIs. SEBI has, thus,
intended to simplify the overall operation of making foreign
portfolio investments in India.

Essentially, foreign portfolio investment entails buying of
securities, traded in another country, which are highly liquid in
nature and, therefore, allow investors to make "quick
money" through their frequent buying and selling. Such
securities may include instruments like stocks and bonds, and
unlike shares, they do not give managerial control to the investor
in a company. To govern FPIs, SEBI introduced the FPI Regulations
by a notification4 dated January 7, 2014. In this
newsletter, we will discuss the legal framework that will govern
FPIs, how FPIs will be taxed and the effect of this new regime on
foreign portfolio investment in India.

1. The FPI Regulations

(a) Classification based registration of investors

FPI has been defined under FPI Regulation 2(h) as a person
meeting the eligibility criteria specified under Regulation 4
(covered under (b) below) and duly registered under Chapter II and
are considered as intermediaries for the purposes of SEBI Act,
1992. Under FPI Regulation 5 the following three categories of FPIs
have been created on the basis of associated risks –
(a) Category I includes foreign investors related
with the government such as central banks, government agencies,
sovereign wealth funds; (b) Category II includes
regulated entities like banks, assets management companies,
investment managers etc. and broad-based funds, which may be
regulated such as mutual funds, investment trusts etc. or
non-regulated; and (c) Category III includes
investors, which are not covered under categories I and II.

The registration requirements are progressively difficult
depending on the category under which the investor falls with
easiest formalities for category I investors. Unlike the previous
situation wherein the QFIs, FIIs and their sub-accounts were
required to register with SEBI for 1-5 years initially to operate,
FPIs registration is carried out by SEBI designated depository
participants5 ("DDPs") on
permanent basis unless suspended or cancelled.6 These
changes may tend to ease out the initial approval process for FPIs
and subsequent operation by them compared to the previous
situation.

(b) Eligibility criteria for FPIs

FPI Regulation 4 prescribes the mandatory eligible criteria for
registration as FPI. Here, the applicant must be a non-resident in
India but non-resident Indians ("NRIs")
are specifically prohibited. While this spells "bad news"
for NRIs, a fund having NRIs as its investors can operate as a FPI
as stated by SEBI. Further, the applicant is required to be a
resident7 of a country which meets the following
criteria- (i) its securities market regulator is a
signatory to the International Organization of Securities
Commission's Multilateral Memorandum of
Understanding8 or party to an MOU with SEBI;
(ii) whose central bank is a member of the Bank
for International Settlements9 in case if the applicant
is a bank; and (iii) not mentioned in the public
statement of Financial Action Task Force10 as a country
having issues related to combating financing of terrorism or money
laundering.

The applicant must also be authorized to invest as per the law
of its country of incorporation or place of business and as per its
Memorandum of Association and Articles of Association or any other
equivalent document. Borrowing from the FII Regulations, the
following conditions have been made applicable for registration as
a FPI - (i) the applicant must have sufficient
experience, professional competence, good track record, financial
soundness and a reputation for fairness and integrity;
(ii) must meet the criteria specified in the SEBI
(Intermediaries) Regulations, 2008 and (iii) grant
of registration to the applicant must be in the interest of
development of the securities market. SEBI may specify any other
criteria from time to time.

(c) Instruments available for investment and prescribed
limits

FPI Regulation 21 provides for the type of instruments in which
FPIs can invest. FPIs can invest in instruments such as listed or
to be listed shares, government securities, units of mutual funds
or collective investment schemes, treasury bills, corporate debt
and Indian depository receipts. For foreign corporates and foreign
individuals, the investment limit now stands increased from 5 to
10% of a company's total issued capital. Also, investment in
equity shares which was previously permissible up to 10% of a
company's total issued capital is now restricted to below 10%.
FPI Regulations prohibit investments in unlisted equity shares of a
company but the existing investments in such securities in which
investment is now prohibited can be kept as such till the sale of
such securities. Investment process for QFIs is easier under the
FPI regulations as they can now, while operating as FPIs, issue
investment instructions directly to their stockbrokers instead of
doing it through qualified depository participants.11
They may also now invest in additional instruments such as
derivatives.

FPI Regulation 22 has brought a major change relating to
issuance of Offshore Derivative Instruments12
("ODIs"). ODIs are significant because
they allow foreign investors, such as high net worth individuals
and hedge funds based overseas, to invest in the Indian market
without being registered with the SEBI. Now, only FPIs, which are
regulated and also fall under Category I or II can issue ODIs.
Under the FII Regulations, ODIs could be issued by all FIIs other
than sub-accounts. Also, unregulated funds cannot subscribe to ODIs
now even if being managed by an appropriately regulated investment
manager which was allowed earlier. A large number of unregulated
hedge funds based in Cayman Islands managed by regulated investment
managers shall be hit by this move. The investor base in ODIs may,
thus, get significantly reduced. After receiving huge opposition
from existing FIIs on this change, SEBI clarified that the new
regulations will not affect existing ODI investments. The FPI
Regulations, however, do not define the expression "persons
who are regulated by an appropriate foreign authority", thus
bringing in the need for more clarity in this regard.

2. Taxation of FPIs

After the FPI Regulations came in force, confusion prevailed
among India Inc regarding the taxation of FPIs. This was because
the different classes of investors were taxed differently
previously and there was no clarity as to how the merged FPI will
be taxed. The Central Board of Direct Taxes
("CBDT") came out with a
notification13 dated January 22, 2014 deeming FPIs
registered under the FPI Regulations as FIIs for taxation purposes.
The notification indicates that all investor classes forming the
FPIs would be taxed similarly to FIIs. QFIs are taxed at the rates
of 40% and 20% on short term capital gains and long term capital
gains, respectively arising from transfer of securities, which are
lower for FIIs under the Income Tax Act, 1961 ("Tax
Act"), i.e. 30% for short term capital gains and 10%
for long term capital gains.14 Similar tax treatment
shall, thus, benefit QFIs through lower taxation under the new law.
However, since the CBDT notification applies FII tax treatment to
FPIs only for purposes of section 115AD of the Tax Act,
applicability of tax benefits that FIIs enjoy under other
provisions such as section 196D15 to FPIs remained
unclear.

The Indian Budget for the year 2014-15 classified income arising
to FPIs from securities' transactions as capital
gains.16 As such, any securities held by a FPI would be
regarded as a "capital asset" as defined in section 2(14)
of the Tax Act so as to treat any income arising from transfer of
such security as a "capital gain". This move ends the
existing uncertainty on classification FPIs' income from their
Indian investments as "business income" or "capital
gains". Tax authorities classify this income as business
income, which is taxed at higher rates than capital gains under the
Tax Act, thus, leading to friction between the tax authorities and
foreign investors. The new clarity in classification of FPIs'
income favors FPIs based out of countries having favorable tax
treaties with India such as Mauritius or Singapore under which
capital gains are exempt from taxation. On the other hand, FPIs of
other countries shall face additional tax burdens. This is because
now they cannot show their income earned from securities'
transactions as "business income" to avoid paying taxes
under the pretext that business income is not taxable in absence of
a business connection or permanent establishment of the foreign
investor in India as per the Tax Act.

3. Implementation timeline

The FPI regime has greatly increased the roles and
responsibilities of the DDPs. Naturally, availability of adequate
infrastructure and facilities with these local custodians is
important for a proper implementation of the law. Based on
representations received from DDPs in this regard, SEBI issued a
circular17 dated March 28, 2014 extending the timeline for
implementation of the FPI regime to June 1, 2014. It was further
clarified that SEBI would continue to accept applications for
registration as FIIs or their sub-accounts till May 31, 2014 after
which the same would be handled by DDPs. This delay in
implementation to give DDPs time to prepare for their additional
responsibilities is understandably better than penalizing them for
non-performance of their duties.

Conclusion

With the ease in registration requirements and clarity on
taxation being brought in for FPIs, the new FPI regime is likely to
boost portfolio investments in India by foreign investors. Granting
of permanent registrations to FPIs shall not require them to
approach the DDPs time and again for the same, thus, providing them
a more supportive environment for investment in India. Meanwhile,
with the delegation of work to DDPs, SEBI can now focus on more
important issues at hand requiring its attention and perform its
regulatory role more effectively. It can be argued that the shift
to the new regime, for all classes of investors that have been
merged, shall be a comfortable one particularly because a buffer
period has been given to them to operate without needing them to
immediately comply with the formalities and process for conversion
to and operation as FPIs.18

Footnotes

1 SEBI (Foreign Institutional Investors) Regulations, 1995
define FII under regulation 2(f) as an institution established or
incorporated outside India that proposes to make investments in
India

2 QFIs are defined under SEBI circular No.
CIR/IMD/DF/14/2011 dated August 9, 2011 as foreign investors who
are entitled to invest in equity and debt schemes of Mutual Funds
in India and are resident in a country that complies with the
Financial Action Task Force standards and is also signatory to
International Organization of Securities Commission's
Multilateral Memorandum of Understanding

3 Sub-accounts are defined under regulation 2(k) of SEBI
(Foreign Institutional Investors) Regulations 1995 as any person
resident outside India on whose behalf investments are made by FIIs
in India and who is registered as sub-account under these
regulations. They include foreign corporate, foreign individual,
broad based funds or portfolios established or incorporated outside
India

4 Notification No. LAD-NRO/GN/2013-14/36/12

5 Regulation 3(1) states that no person can buy, sell or
otherwise deal in securities as a foreign portfolio investor unless
a certificate to that effect has been granted by the designated
depository participant on behalf of SEBI

6 Regulation 10(2) of the FPI Regulations states that
suspension or cancellation of the registration would be dealt with
by the DDP in the manner indicated in Chapter V of the SEBI
(Intermediaries) Regulations, 2008

7 Explanation to Regulation 4 states that the terms
"resident" and "non-resident" have to be
interpreted as per their meanings stated under the Income Tax Act,
1961

8 IOSCO is an international body that was established in
1983 in Madrid, Spain and seeks to develop and promote standards
for regulating securities' markets of different countries to
enhance investor protection at a global level. The Multilateral MOU
was formulated by IOSCO in 2002 to promote co-operation and
information exchange among its members to prevent practices as
fraud, price manipulation and insider trading

9 The Bank for International Settlements is headquartered
in Basel, Switzerland that aims to ensure monetary and financial
corporation at an international level among central banks of
different countries

10 Financial Action Task Force is an inter-governmental
body formed in 1989, which aims to set global standards and
policies aimed at combating money laundering and terrorist
financing activities and it is headquartered in Paris 11
http://www.thehindubusinessline.com/features/investment-world/melange/one-window-for-foreign-investors-is-a-welcome-move/article5645803.ece
last accessed on August 16, 2014

12 Defined under regulation 2(j) as any instrument issued
overseas by a FPI against underlying securities held by it that are
listed or proposed to be listed on any recognized stock exchange in
India

13 Notification No. 9/2014

14 As stated under section 115AD(1) of the Tax
Act

15 Section 196D prohibits deduction of tax at source from
income payable to an FII by way of capital gains on transfer of
securities

16 Under paragraph 201 of part B(XII) of the Budget, full
text of the Budget 2014-15 available at
http://zeenews.india.com/business/indian-budget-2014/union-budget-2014-15-full-text_103644.html
(last visited on August 7, 2014)

17 Circular No. CIR/IMD/FIIC/6/2014

18 Regulation 3(1) of the FPI Regulations allows existing
FIIs and sub-accounts to operate till expiry of their registration
with SEBI and QFIs can also operate for a period of 1 year after
commencement of the regulations subject to them obtaining
registration as a FPI earlier than the expiry of the registration
or end of the 1 year period respectively

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